Question

How can you relate Stress and Scenario Testing to an entity’s ability to sustain its earnings over a period of time?

Answer 1

Answer :

Scenario analysis is the process of evaluating the impact of specified scenarios on the company's financial position. Stress testing is the process where we evaluate a number of statistically defined possibilities to determine the most damaging combination of events, and the loss they would produce. Stress testing is a computer simulation technique used to test the resilience of institutions and investment portfolios against possible future financial situations. Examples of Stress Testing : Stress testing refers to a type of testing that is so harsh, it is expected to push the program to failure. For example, we might flood a web application with data, connections, and so on until it finally crashes. Buffer overflows are classic examples of stress test results.

Use of stress testing and integration in risk governance

Changes in stress testing practices since the outbreak of the turmoil Given the unexpected severity of events, stress testing has gained greater prominence and credibility within banks as a complementary risk management tool to provide a different risk perspective. It is important that this process continues so that stress testing programmes become embedded in banks’ governance structures. Moreover, this process needs to be led by the board and senior management. Banks recognise that current stress testing frameworks must be enhanced both in terms of granularity of risk representation and the range of risks considered. Some banks have started to address these issues and other weaknesses of stress tests for the specific risks identified above. More general areas in which banks are considering future improvement include:

• constantly reviewing scenarios and looking for new ones;
• examining new products to identify potential risks;
• improving the identification and aggregation of correlated risks across books as well as the interactions between market, credit and liquidity risk; and
• evaluating appropriate time horizons and feedback effects.

Relating Stress and Scenario Testing to an entity’s ability to sustain its earnings over a period of time: Use of stress testing and integration in risk governance

1. Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting decision making at the appropriate management level, including strategic business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation.

2. A bank should operate a stress testing programme that: promotes risk identification and control; provides a complementary risk perspective to other risk management tools; improves capital and liquidity management; and enhances internal and external communication.

3. Stress testing programmes should take account of views from across the organisation and should cover a range of perspectives and techniques

4. A bank should have written policies and procedures governing the stress testing programme. The operation of the programme should be appropriately documented.

5. A bank should have a suitably robust infrastructure in place, which is sufficiently flexible to accommodate different and possibly changing stress tests at an appropriate level of granularity.

6. A bank should regularly maintain and update its stress testing framework. The effectiveness of the stress testing programme, as well as the robustness of major individual components, should be assessed regularly and independently.

7. Stress tests should cover a range of risks and business areas, including at the firm-wide level. A bank should be able to integrate effectively across the range of its stress testing activities to deliver a complete picture of firm-wide risk.

8. Stress testing programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.

9. Stress tests should be geared towards the events capable of generating most damage whether through size of loss or through loss of reputation. A stress testing programme should also determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.

10. As part of an overall stress testing programme, a bank should aim to take account of simultaneous pressures in funding and asset markets, and the impact of a reduction in market liquidity on exposure valuation.

11. The effectiveness of risk mitigation techniques should be systematically challenged.

12. The stress testing programme should explicitly cover complex and bespoke products such as securitised exposures. Stress tests for securitised assets should consider the underlying assets, their exposure to systematic market factors, relevant contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the subordination level in the issue structure.

13. The stress testing programme should cover pipeline and warehousing risks. A bank should include such exposures in its stress tests regardless of their probability of being securitised.

14. A bank should enhance its stress testing methodologies to capture the effect of reputational risk. The bank should integrate risks arising from off-balance sheet vehicles and other related entities in its stress testing programme

15. A bank should enhance its stress testing approaches for highly leveraged counterparties in considering its vulnerability to specific asset categories or market movements and in assessing potential wrong-way risk related to risk mitigating techniques.

16. Supervisors should make regular and comprehensive assessments of banks’ stress testing programmes.

17. Supervisors should require management to take corrective action if material deficiencies in the stress testing programme are identified or if the results of stress tests are not adequately taken into consideration in the decisionmaking process.

18. Supervisors should assess and if necessary challenge the scope and severity of firm-wide scenarios. Supervisors may ask banks to use specific scenarios or to evaluate scenarios under which their viability is threatened (reverse stress testing scenarios).

19. Under Pillar 2, supervisors should examine a bank’s stress testing results as part of a supervisory review of both the bank’s internal capital assessment and its liquidity risk management. In particular, supervisors should consider the results of forward-looking stress testing for assessing the adequacy of capital and liquidity.

20. Supervisors should consider implementing stress test exercises based on common scenarios.

21. Supervisors should engage in a constructive dialogue with other public authorities and the industry to identify systemic vulnerabilities. Supervisors should also ensure that they have the capacity and the skills to assess banks’ stress testing programmes.